Currency carry trade in emerging market countries

Abstract

This dissertation comprises of two purposes: 1) to examine the causal relationship and the volatility spillover between returns of carry trade strategies and equity markets; and 2) to demonstrate the time-varying risk premium of the carry trade. The Granger causality test under the Vector Autoregressive (VAR) model and the multivariate DCC-GARCH (1,1) are employed for the first purpose. The second one adopts the multi-factor model and the Logistic Smooth Transition Regression (LSTAR) for pricing carry trade returns which depend on the returns of equity and bond factors. The risk exposures to factors are allowed to vary across FX volatility regimes. The daily data of ASEAN-5 emerging markets and developed economies span from August 2006 to March 2015, covering 2,251 observations.

The empirical results show that carry trade portfolio returns of G10 currencies strongly Granger cause returns of equity markets in all developed economies and ASEAN-5 emerging markets. Higher carry trade portfolio returns significantly lead to greater returns in most stock markets regardless of the environments they operate in. The finding of this study is that the US dollar has been more popular in funding for carry trade strategies than the Japanese yen. Conversely the currencies of all ASEAN5 emerging countries have been used for investment purposes. Moreover, there exists the volatility spillover from the carry trade market to all ASEAN-5 equity markets. The information transmission from the carry trade market to equity markets is rather examined for ASEAN-5 emerging markets than developed economies. The empirical results also indicate that carry trade returns are positively exposed to equity market returns in ASEAN-5 rather than in developed countries. The risk premium of the carry trade becomes greater during more volatile periods, no matter what the foreign exchange rate policy is adopted.

Overall, the main results show that the carry trade significantly causes highyielding assets like stocks to move together with carry trade returns. Speculators seek to invest in stocks of emerging markets when they involve in carry trade strategies. As such, the overall evidence suggests that the UIP condition does not seem to hold in emerging markets. In addition, equity markets are regime-dependent. The carry trade yields higher returns in the form of compensation to the higher risk premium when investing in ASEAN-5 equity markets during volatile periods. The risk premium would need to be introduced into the UIP condition.